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Examining the Chinese Exchange Rate Reform and the Possibility of the Chinese Yuan Becoming a Regional Trade Currency: Yuan CurrencyIn order for a currency to gain international importance, there has to be a strong demand for it by three entities: the world’s traders, the world’s investors and the world’s central bankers. The currency has to be considered as a medium of exchange for foreign trade settlement, a unit of account for denominating international financial transactions and a store of value for central banks’ foreign exchange reserves.
In addition to the three elements of an international currency, there are three determinants of currency internationalization. They are the size of an economy and its trade volume, the breadth, depth and liquidity of its capital markets and third, the stability and convertibility of its currency. For instance, the dollar, euro and yen account for 28.5%, 22.0% and 11.2% of the world GDP respectively. However, compared to China, it is only 4.6 % as shown in figure 4. China accounts for 5.1% of the world’s trade volume which is lower than the U.S. trade volume that accounts for 13%. China also works in expanding the role of its currency to evolve into a major currency for cross-border trade settlement with countries such as Vietnam, Cambodia, Russia and Mongolia. In 2008, China government announced pilot program to allow provinces such as the Yangtze River Delta, Guangxi and Yunnan to use the Yuan to settle commercial transactions with selected members of the Association of Southeast Asian Nations.
China also has entered into two-sided currency-swap agreements with a number of trading partners in order to mitigate exchange-rate risks arising from trade settlement in the dollar. For instance, in 2008, the PBC signed currency-swap agreements with South Korea, Indonesia, Malaysia, Argentina, and Belarus with a total value of RMB 650 billion. Consequently, the Chinese government is starting to push the RMB on a liberalization path to raise its profile as a regional medium of exchange.
For any country planning to internationalize the role of its currency, it should offer open and sophisticated transaction venues where foreign dealers can trade a range of currency-denominated financial products and place regulatory and macroeconomic safeguards to minimize the unit’s volatility and exchange rate-related risk. This is true for countries with less restriction on capital account transactions because they are more likely to promote short-term portfolio inflows and outflows and consequently tend to facilitate high and far-reaching circulation of their currencies offshore.
When we compare the Chinese capital market with other capital markets elsewhere we can see clearly that China capital market is still in its early stage and it may take one or two decades for China to develop capital markets with comparable breadth and depth.
First, China’s domestic capital market has limited opportunities for Chinese companies to fund-raising when compared to other markets worldwide. Moreover, relative to other major currency countries, China has lower equity and bond market capitalizations to GDP ratios. According to the Deutsche Bank Research cited in Wu for instance, China’s equity and bond market capitalizations only account for 5.9% and 2.4% of the world’s equity and bond markets respectively and the banking sector account for only 9.1% of total global bank assets.
Second, because of access barriers to China’s capital markets, the interaction and openness with foreign markets are very restricted. For example, due to China’s capital markets restrictions, the inward portfolio investments from 2003 to 2007 represented a mere 0.7% of the total portfolio investments globally. Third, the integration between China’s capital market and the international market system is difficult because of constraints such as high transaction costs, and weak supervisory and regulatory frameworks. For example China still practices a merit-based approval system compared to registration-based systems in most overseas mature capital markets. Another constraint is the transaction costs. The average transaction cost for bonds in China is 6.3 basis points which are relatively high compared the rest of the world. For example the United Kingdom, U.S. and Japan have 1.0, 0.4 and 0.5 basis points respectively. In view of that, the Chinese financial system has to be reformed in order to compete globally through elimination of bureaucracy and substantial reduction in transaction costs.

Figure-4

Figure 4: Comparison of Reserve Currencies